Perfect Market Efficiency: Reality or an idealistic view?

The recent fall in crude oil prices has created large disruption to global oil companies, including Exxon Mobil who experienced a 21% fall in profits during Q4 2014 (Carroll 2015, Krauss 2015 & Driver 2015). This led me to question how efficiently the market is responding to such changes and what, if any, there impact is on Exxon’s share price.

There are 3 different types of stock market efficiency; Operational, Allocational and Pricing. The focus of this blog will be pricing; assessing how well a market responds to new information. In an efficient capital market share prices accurately reflect all information that is publically available, rendering it impossible to develop trading rules to ‘beat the market’. The efficient market hypothesis (EMH) states any new information revealed about a company will be incorporated into the share price rapidly and logically. Therefore, stock market efficiency means share prices reflect their true economic value. Would it not, therefore, be rational to expect the 21% drop in Exxon’s profit to be reflected by a reduced market value?

EMH argues news is unpredictable making future price changes impossible to forecast. Kendall (1953) provided evidence of a random walk hypothesis, finding no logical link between one price movement and succeeding ones. It follows that share prices will be random, since they reflect new information which is unpredictable. On the basis of this, it could be argued statistical, technical analysis of share prices is effectively irrelevant. Conversely, a counter argument could be presented in the fact that many large companies still employ technical analysts implying they find their skills to be useful.

Fama (1970) developed Kendall’s initial findings, proposing three forms of market efficiency. The first was weak form, proposing share prices reflect all historical movements and information. Any profits generated in excess of the market return will be done so by chance. There is an array of evidence strongly supporting this theory. In terms of Exxon, the announcement of a 21% fall in profits during the fourth quarter of 2014 should not be immediately incorporated into their share price. Supporting this, on 2^nd February, the day of the announcement, Exxon’s shares ended the day’s trading 2.5% higher, outpacing the gain in the overall market. Does this lack of immediate reflection in the share price imply a slow reaction from the market? 

                                                                                                                 Figure 1. Exxon Mobil share price. 
                                                                                                                 Note. NASDAQ, 2015

Perhaps, but as displayed in figure 1, Exxon’s share price fell by almost 5% in the 6 days leading up to the announcement. This premature impact on the share price could lead some to conclude investors had an indication about the fall in profits, seemingly possessing some level of insider knowledge. This would provide support for strong form market efficiency, in which share prices reflect all information regardless of whether it is publically available. In this situation no one can make abnormal returns. However, in instances involving insider dealing, in which an insider or group has access to information that is not publically available, abnormal returns have been seen. This form is best viewed as a benchmark against which market inefficiency can be judged.

A much more credible explanation, at least in my opinion, is that investors were aware of the impact the falling oil industry would have in the forthcoming profit announcement from Exxon. Oil markets are oversupplied whilst demand is declining, resulting in falling prices. The price of crude oil, seen as the international benchmark, fell by more than a third in the final quarter of 2014. It surely then came as no surprise that Exxon’s fourth quarter profits were negatively impacted, arguably explaining the drop in share price in the days leading up to the announcement.

This argument provides support for the semi-strong form of market efficiency; share prices reflect all historic movements as well as publically available information. Semi-strong market efficiency supports EMH, arguing share prices react quickly and logically to new information. The 2.5% increase on the day Exxon announced their profit, and the subsequent increase the following day, could be a result of the company’s statement regarding dividends. They announced the 9.5% increase in dividends remains unaffected, which may have restored investor confidence. It may also be worth noting that due to the current uncertainty of the oil industry, in which prices plummeted further in January, share prices are likely to be volatile for the coming months.

The efficient market theory has been heavily criticised for various reasons, including behavioural issues. Investors may not always make rational decisions, but may be overruled by cognitive reflexes such as overconfidence. However, stock market efficiency is vital for shareholder wealth maximisation; an important aspect of most businesses, discussed in my previous blog. Market efficiency makes this seem like a realistic goal, although some have claimed it may tempt managers to hold back negative information. It is clear the market is not perfectly efficient, as it is impossible for market values to reflect all information. Rather, investors rely on a flow of information to the market to allow share prices to incorporate new information and reflect their true value. In my opinion Kendall’s Random walk hypothesis provides the best account of share prices. Information cannot be predicted, nor can the way in which investors will react to this news. Therefore, accurate forecasts cannot be made, suggesting share prices are in fact ‘random’.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Carroll, J. (2015). Exxon Profit Declines After Oil Market Collapse. Retrieved 18 February 2015, from http://www.bloomberg.com/news/articles/2015-02-02/exxon-profit-declines-as-oil-industry-reels-from-market-collapse

Driver, A. (2015). Exxon fourth-quarter profit tops estimate, share buyback slasher in half. Retrieved 18 February 2015, from http://www.reuters.com/article/2015/02/02/us-exxon-results-idUSKBN0L618820150202

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, 25(2), 383-417. Retrieved from JSTOR http://www.jstor.org/

Kendall, M. (1953). The Analysis of Economic Time-Series – Part 1: Prices, Journal of the Royal Statistical Society, 116(1), 11-34. Retrieved from JSTOR http://www.jstor.org/

Krauss, C. (2015). Exxon Mobil Revenue and Profit off 21% on Oil Decline. Retrieved 19 February 2015, from http://www.nytimes.com/2015/02/03/business/energy-environment/exxon-mobil-q4-earnings-decline.html?_r=0

NASDAQ. (2015). Exxon Mobil share price. Retrieved 18 February 2015, from http://www.nasdaq.com/symbol/xom/interactive-chart

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Tesco's shareholder wealth maximisation - Or lack of?

The primary objective of value based management is long term, sustainable shareholder wealth maximisation. A company’s share price is considered an indicator of shareholder wealth maximisation, as it considers future dividend payments and investor views. It follows that shareholders, as the owners of the company who bear the most risk, deserve a proportion of company profits. By maximising shareholder value, a company can expect to attract further investment and be viewed as successful in the financial market.

Over the past 6 months supermarket giant Tesco has experienced a very public fall from grace. As a consequence, many believe shareholder wealth has been destroyed. During the fourth quarter of 2014, Tesco issued its fourth profit warning in six months, concluding a disastrous year for the company. The announcement stated trading profits for the year ending February 2015 would not exceed £1.4bn. With already reduced market forecasts of £1.9bn, this is a £500m reduction. Whilst profits do no directly affect shareholder wealth, they do influence it. Profit warnings are perceived by financial markets as a sign of financial weakness. This fall in profits may have been the initial source of investors beginning to lose confidence. In my opinion, this fall in confidence is likely to have been reinforced by top shareholders in Tesco selling shares in the months around this.

Market share is considered to be associated with shareholder wealth and is usually set as a strategic objective to help maximise this wealth. Improving market share generates economies of scale, creates barriers to entry for potential competitors and encourages brand loyalty. Such benefits all link to shareholder wealth, albeit indirectly. An obsession with margins and an obsessive quest for market share has negatively impacted other aspects of Tesco, including shareholder wealth. Tesco are under increasing pressure to protect market share from upcoming, low cost supermarkets such as Aldi. Despite their attempts, Tesco’s market share fell from 29.9% to 29.1% over the course of 2014. Conversely, the market shares of Aldi and Lidl grew. Analysts have predicted a prolonged price war in the supermarket industry, leading to the demise of many of the current companies. Tesco admitted it is losing an escalating supermarket price war to discount rivals Aldi and Lidl, which could be a cause for concern for shareholders.

In late 2014, Tesco admitted misstating its profits by £263m, representing another blow to the company. This arose as Tesco had been doing deals with suppliers over promotions, but failing to report them accurately. Returns were recorded too early and costs were pushed back. The practice of stretching accounting regulations to the limit eventually catches up with companies, as it did with Tesco. Such practices stop the company meeting investor expectations and partly destroy market value. The incident reduced the value of Tesco by billions. Consequently, eight executives were suspended whilst an investigation was carried out. Four of these are now believed to have left the company. However, today Tesco announced they would make a pay out to the ousted CEO and ex-finance chief. This pay-out has a combined value of almost £2.2m, further undermining shareholders and questioning Tesco’s creation of shareholder wealth.

Perhaps not surprisingly, share prices of Tesco have plummeted in light of these events. Share price halved over a twelve month period, falling by 44% over the past year, compared to a 2% rise for the wider FTSE100, seen in the graph below. During this period the share price reached its lowest in 14 years. Accordingly, this dramatically reduced shareholders capital gains. In August, Tesco cut their dividend by 75%. They have recently announced they will pay no dividend for the financial year 2014/15 in a bid to reduce capital expenditure. Whilst this reduces shareholder wealth, it shows their commitment to the long term success of the company which may help improve shareholder wealth in the future.

 The share price is gradually recovering and is currently up 2.1%. It is nearing pre-overstatement level for the first time in 4 months. Despite this, some have claimed the fall out of the events discussed above have caused investors to lose interest in waiting for a recovery which still seems a long way off. However, there is some hope for Tesco who announced the biggest overhaul in their history last month. This includes closing 43 stores, cutting thousands of jobs and scrapping the dividend. The company is also close to naming their next chairman.  I believe Tesco lost sight of their strategic objectives that assisted them in maximising shareholder wealth in their quest for high profits and market share without consciously recognising it. With some restructuring and refocus, the company has the ability to gradually restore the confidence of shareholders, albeit through an uphill, time consuming battle. The ongoing supermarket price war, which will impact the supermarket industry as a whole, is likely to remain a concern for shareholders of Tesco well into the future.

REFERENCES

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

BBC. (2014). Tesco shares plunge after profit warning. Retrieved 3 February 2015, from http://www.bbc.co.uk/news/business-30391447

Economic Times. (2015). Tesco pays out to ousted CEO Phil Clarke and ex-finance chief Laurie McIlwee. Retrieved 3 February 2015, from http://economictimes.indiatimes.com/news/international/business/tesco-pays-out-to-ousted-ceo-phil-clarke-and-ex-finance-chief-laurie-mcilwee/articleshow/46108077.cms

Felsted, A., Oakley, D. & Barrett, C. (2014). Tesco issues fourth profit warning in a year. Retrieved 3 February 2015, from http://www.ft.com/cms/s/0/f7fe75c0-7f72-11e4-b4f5-00144feabdc0.html#axzz3QgHTlpkR

Financial Times. (2015). Tesco to cut spending to £1bn, axes dividend. Retrieved 3 February 2015, from http://www.ft.com/fastft/258262/tesco-cut-spending-1bn-axes-divi

Neilan, C. Tesco's share price nears pre-overstatement level for the first time in four months. Retrieved 3 February 2015, from http://www.cityam.com/207114/tescos-share-price-nears-pre-overstatement-level-first-time-four-months

Rappaport, A. (2006) Ten Ways to Create Shareholder Value, Harvard Business Review, 84 (9), pp. 66-77. Retrieved from Serials Solutions http://jr3tv3gd5w.search.serialssolutions.com/

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Wood, Z. (2014). Tesco shares fall to touch 14-year low as annual profits face £500m dip. Retrieved 3 February 2015, from http://www.theguardian.com/business/2014/dec/09/tesco-share-price-falls-500m-profit-plunge-dave-lewis